Synthetic resecuritizations were issued in the domestic market in larger numbers this year that ever before. However, the models are so fresh they haven't exactly been reconciled with ISDA credit event definations.
First blipping on the radar in late 1990s in Europe, these deals were not a flavor for the U.S. palate until 2003, thanks to reduced opportunity for capturing arbitrage in corporate deals, sources said.
At least eight synthetic resecuritzation CDOs were issued in the U.S. this year, said Yuri Yoshizawa, vice president/senior credit officer at Moody's Investors Service. Varying in size, the vehicles have all tended to be larger than traditional cash CDOs, with some upwards of $9 billion or $10 billion for the reference pool.
These new CDOs reference pools of structured finance securities synthetically, combining the advantages of cash resecuritization CDOs and plain, old corporate synthetic CDOs. Similar in structure to the latter, this type of CDO does not own underlying assets outright, but accesses them though credit default swaps.
And therein lies the twist - how to account for events affecting these new vehicles using the International Swaps and Derivatives Association's (ISDA) standard credit derivative definitions.
Structurally, there is not a huge difference between the new synthetic resecuritizations and regular synthetic CDOs of corporate names, said Yoshizawa. For example, both types of CDOs have a recovery or evaluation mechanism, and can have waterfalls or not (as single-tranche versions have cropped up). But the key difference is in the way synthetic resecuritizations define credit events.
ISDA definitions were not written with the anticipation they would be used for structured finance reference assets.
"Synthetic resecuritizations are very customized in their language because there is no standardized language out there. You will see different credit event definitions by the structurer that is responsible for putting together the deal," said Yoshizawa. What these deals have done has varied from taking ISDA language and modifying it to creating their own language.
The most common credit events for synthetic resecuritizations have concerned either failure to pay or, as Yoshizawa terms them, loss events.
"However, there's no real parallel for [loss events] in the corporate world. Corporate bonds and loans typically do not get written down," Yoshizawa said.
On the other hand, write-downs are very much a part of the structured finance world, where assets are written down as the pools that back it deteriorate. "ISDA [definitions] do not have a loss event or principal write-down credit event. [Or] you look at the bankruptcy definition in ISDA, (and) it's not meant to take into account the bankruptcy of a non-operating entity, so that is another area where it really doesn't apply," Yoshizawa explained.
Other gray areas include restructuring, which is another event not really seen in the structured finance world but is very much a part of the credit default swaps market. At the end of the day, investors need to pay special attention to the specific language incorporated into the deal document of the synthetic resecuritization CDOs and not rely solely on the language agreed upon in the CDS market.
There is no proposal currently on the table to address definitions for synthetic CDOs or structured finance, said Louise Marshall, policy director and head of communications for ISDA. "But we take a look at issues if there's a significant interest from our membership," said Marshall.